Planning Ideas IRC Section 303 Redemptions

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1 Planning Ideas IRC Section 303 Redemptions When a business owner client says he wants to leave his successful business to one or more of his children, a number of questions arise including the following: Is the selected successor qualified to run the business? Will management and other family members respect and follow the selected successor? When will the transition occur following the death of the current owner or during his or her lifetime? What is the value of the business? What will the owner do to assure that other heirs are treated fairly? Will the surviving spouse have adequate income? How will estate and inheritance taxes, administrative costs, and funeral expenses be paid? A good plan might be to recapitalize the business so that income and control of the business are separated from future growth. This is often accomplished through the vehicle of a family limited partnership (FLP) or family limited liability company (LLC). In either case the current business owner retains management control and income rights while the successor and/or other family members enjoy the future growth. At retirement or death, control can be shifted to the successor while retaining income rights for the surviving spouse. While not without its own issues, especially valuation of the partnership or LLC interests, this divide and conquer strategy addresses many of the questions raised above. 1

2 Figure 1--Divide and Conquer CONTROL (voting - 1%) Senior Generation Control Income SENIOR GENERATION EQUITY (nonvoting 90%) EQUITY (nonvoting - 99%) JUNIOR/3 rd GENERATION, TRUST (creditors, litigation, divorce), or CHARITY/COMMUNITY But what about the client who procrastinates, as many clients are wont to do? He hears your advice, but doesn t listen, and drags his feet. Time passes, and one day you receive a phone call. The client has passed away. His solely owned $20 million business makes up 80 to 90 percent of his estate. The ten or twenty percent of the estate that is not the business consists of the now deceased client s residences, automobiles, other toys, and $2 million squirreled away in mutual funds. After bequeathing the stock in his business to his oldest son, who is involved in the dayto-day operations of the business, the client s estate planning documents divide his estate among a family trust, which benefits two inactive children, and a marital trust. The family trust receives any unused exemption amount and the marital share the balance. It doesn t take a rocket scientist to realize that the client s estate faces a liquidity crunch. State and federal taxes, administrative costs, and funeral expenses of about $7 million are due and payable, and even after taking into account the cash available from sale of the mutual fund shares, the estate faces $5 million in death costs. Not only that, the surviving spouse is frantic; she s unemployed by the business, and already she s wondering where the income will come from to provide her with enough income to live in the style to which she s become accustomed. As for Son #1 s younger siblings, they re gainfully 2

3 employed, but both are deep in debt. They were really counting on their inheritance to get right with creditors, and they want to know why their older brother should get all the goodies. Of course, the family is looking to you to sort all of this out. If you can, the prize is a happy surviving spouse and three younger-generation beneficiaries who will love you and engage your services forever. IRC Section 303 to the Rescue IRC Section 303 seems a little old-fashioned in today s world of FLPs, family LLCs, irrevocable life insurance trusts (ILITs), and intentionally defective grantor trusts (IDGTs). In fact, it was enacted over fifty years ago as part of the Internal Revenue Code of In what may seem a little quaint in today s political environment, a unified Congress wanted to make it easier for small For business owner clients needing cash to pay death costs, Section 303 can be a savior. Cash from the business can be tapped to meet liquidity needs, leaving other assets in place to fund bequests and/or provide income to a surviving spouse. businesses to pass from generation to generation. This was at a time when the estate tax exemption was $60,000, the top rate was 77 percent, and no more than half of the estate could qualify for the marital deduction. The gist of IRC Section 303 is that distributions in redemption of a deceased shareholder s stock are treated not as a dividend but as a capital transaction, up to a certain amount and provided the estate qualifies. Without Section 303, a distribution in partial redemption of a decedent s stock would most likely be fully taxable at ordinary income tax rates. With Section 303, a qualifying redemption would be taxable only to the extent that the amount of the redemption exceeded the estate or beneficiary s basis. Given that basis would be stepped-up at death, there would probably be little or no taxable gain. Thus, without Section 303 a $1million distribution would receive a tax hit of about $350,000. With Section 303, the tax hit would be about zero. For business owner clients needing cash to pay death costs, Section 303 can be a savior. Cash from the business can be tapped to meet liquidity needs, leaving other assets in place to fund bequests and/or provide income to a surviving spouse. 3

4 Qualifying Amount The amount that qualifies for the favorable tax treatment granted by Section 303 is limited to the sum of the following: The estate, inheritance, legacy, and succession taxes (including any interest collected as a part of such taxes imposed because of such decedent's death); and The amount of funeral and administration expenses allowable as deductions to the estate under section 2053 (or under section 2106 in the case of the estate of a decedent nonresident, not a citizen of the United States). Thus, even in situations where no federal tax is imposed due to the increased exemption of $5 million, Section 303 could nevertheless be relied on to the amount of state inheritance and estate tax, funeral expenses, and administrative expenses. In many instances, qualification for Section 303 will be a foregone conclusion, but it s important to note that the requirements that the redeemed stock be included in the decedent s gross estate and make up more than 35 percent of the adjusted gross estate make qualification for Section 303 treatment anything but certain until after death. It is only after death that the relative values of estate assets will be known. Consequently, a Section 303 redemption is best thought of as a post mortem estate planning tool. In addition, a special rule applies to allow for redemptions up to the amount of generationskipping taxes imposed. Note that the amount received in distribution of stock does not have to be applied to taxes or administrative and funeral expenses. These items merely limit the amount that qualifies the Section 303 tax break. Qualifying Estates To be eligible for Section 303 treatment, the value of the decedent s stock included in the gross estate must exceed 35 percent of the value of the adjusted gross estate. For purposes of this requirement, stock of two or more corporations, with respect to each of which there is include in determining the value of the decedent s gross estate 20 percent or more in value of the outstanding stock, will be treated as the stock of a single corporation. For purposes of the 20-percent requirement, stock which, at the decedent's death, represents the surviving spouse s interest in property held by the decedent and the surviving spouse as community property or as joint tenants, tenants by the entirety, or tenants in common is treated as having been included in determining the value of the decedent's gross estate. 4

5 In many instances, qualification for Section 303 will be a foregone conclusion, but it s important to note that the requirements that the redeemed stock be included in the decedent s gross estate and make up more than 35 percent of the adjusted gross estate make qualification for Section 303 treatment anything but certain until after death. It is only after death that the relative values of estate assets will be known. Consequently, a Section 303 redemption is best thought of as a postmortem estate planning tool. Qualifying Distributee Although the distribution in redemption under Section 303 does not have to be used to pay taxes and expenses, the interest of the shareholder from whom the stock is redeemed must be reduced directly (or through a binding obligation to contribute) by payment of taxes or expenses. In general, this means that the estate or beneficiary from whom the stock is redeemed must be liable for the estate or inheritance taxes and administrative and funeral expenses. Usually, this requirement does not present an obstacle. Qualifying Time Period In general, in order to qualify under Section 303, the redemption must take place after the business owner s death and no later than (1) three years and 90 days from the due date of the federal estate tax return; or (2) 60 days after a tax court decision in an estate tax liability contest has become final; or (3) the time permitted for the payment of estate tax installments, pursuant to IRC Section 6166, if applicable. However, in situations where corporate distributions on a redemption are made more than four years after the decedent s death, the distribution by the corporation is subject to Section 303 only to the extent of the lesser of (i) the amount of taxes, funeral and administration expenses remaining unpaid at that time, or (ii) the taxes and expenses that are actually paid within one year of the distribution. Other Considerations Another key consideration with Section 303 redemptions relates to where the corporation will find the cash (or other property) to implement the redemption. Obvious alternatives include cash on hand, cash from life insurance proceeds received from policies owned by the corporation on the decedent s life, and cash borrowed from a lender. Some states require that any stock redemption be paid for with corporate surplus. Permanent life insurance on the life of the owner may be used to create the necessary surplus. 5 Keep in mind, that even if the estate doesn t need cash, a Section 303 redemption can be a tax efficient way of getting cash out of the business that would otherwise have been taxed as a dividend when distributed. Remember, there is no tracing requirement on funds received in a Section 303 redemption.

6 Bottom Line For clients with successful businesses and a potentially large estate tax bill, a divide and conquer strategy utilizing a FLP or family LLC is likely to be the best way to go. But for clients who fail to plan, procrastinate, or get caught short of cash following the owner s death, an IRC Section 303 redemption can be a lifesaver. Also, keep in mind, that even if the estate doesn t need cash, a Section 303 redemption can be a tax-efficient way of getting cash out of the business that otherwise would have been taxed as a dividend when distributed. Remember, there is no tracing requirement on funds received in a Section 303 redemption. Planning Ideas and similar topics are covered in great detail in many of Cannon s professional development solutions. To find out more visit: Copyright 2011 Cannon Financial Institute - All Rights Reserved Disclaimer: The materials and information contained herein are intended for educational purposes, to stimulate thought and discussion so as to provide the reader with useful ideas in the area of wealth management planning. These materials and information do not constitute and should not be considered to be tax, accounting, investment, or legal advice regarding the use of any particular wealth management, estate planning, or other technique, device, or suggestion, nor any of the legal, accounting, tax, or other consequences associated with them. While the content herein is based upon information believed to be reliable, no representation or warranty is given as to its accuracy or completeness. For this reason, the program of study should not be relied upon as such. Although effort has been made to ensure the accuracy of these materials, you should verify independently all statements made in the materials before applying them to your particular fact pattern with a client. You should also determine independently the legal, investment, accounting, tax, and other consequences of using any particular device, technique, or suggestions, and before using them in your own wealth management planning or with a client or prospect. Information, concepts, and opinions provided herein are subject to change without notice. The strategies contained within these materials may not be suitable for all clients. For many concepts discussed herein, clients are strongly urged to consult with their own advisors regarding any potential strategy and will need to strategy described herein is suitable for their particular circumstances. Examples, provided throughout these materials, are for illustrative purposes only, and no representation is being made that a client will or is likely to achieve the results shown. The examples shown are purely fictional and are not based upon any particular client's circumstances. 6